Bond Bubble? What You Can Do About It.

By

Brett Arends

Updated Feb. 21, 2010 11:59 p.m. ET

Are bonds in a bubble? And, if so, what can you do to protect yourself?

This is a key question for millions of investors -- especially after the Federal Reserve's surprise move last week to raise one of its interest rates. That's often considered a signal the Fed is about to raise rates more broadly, a move that would be ominous for bonds.

Brett Arends joins the News Hub to discuss whether investors needs to be protecting themselves from a bond bubble.

Bonds are IOUs issued by governments and corporations. They are generally deemed more stable than stocks. Today the public has more than $2.2 trillion invested in bonds through mutual funds.

Bond sales have boomed in the past year, as investors have sought more stability in the wake of the stock-market crash.

According to the Investment Company Institute, a trade body for the mutual-fund industry, investors have poured nearly $400 billion into bond funds since the start of 2009.

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Chris Gash

But booming sales have driven up prices. Corporate bonds have become more and more expensive. And U.S. Treasury bonds look even more so.

These days a seven-to-10 year bond from a top-rated company will pay you only about 4.3%. Even a year ago that was above 6%, and not long ago it was higher still. Meanwhile, a 10-year Treasury bond will pay a paltry 3.8%. During the financial crisis it briefly went lower, but by the standards of recent decades it is near the floor.

Why does this matter? Bondholders may not know it, but they are taking risks. The biggest is from inflation. When consumer prices rise, the fixed interest you get from your bonds is worth less and less in real, purchasing-power terms.

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If the bonds' yields are high enough to compensate, this may not matter. But if yields are low, like now, and inflation takes off you can get into trouble. Those who invested in long-term Treasury bonds in the mid-1960s, just before inflation surged, actually lost money in real terms over the following 20 years. (Those who bought bonds in the early 1980s, when yields went as high as 15%, made out like bandits as inflation collapsed.)

When inflation rises the government usually raises short-term interest rates. And that's an additional problem for bondholders. When short-term savings accounts are paying about 1% a year, a piece of paper from a company promising 3.8% a year for 10 years can look quite valuable. But it'll be worth a lot less if short-term rates were to rise to, say, 5%, or even more.

Are we definitely in a bond bubble? Even though prices seem high, it's not certain. Some people argue that they are a reasonable value, and inflation will stay subdued. Indeed one or two bearish strategists argue bonds could go even higher, and yields lower. Only time will tell.

There are very few certainties in the financial markets. For private investors, the key is to make sure you're getting paid for the risks you're taking. In the case of anyone holding long-term bonds, you're probably not.

What can you do about it? Here are three practical steps to take if you are worried:

1 Limit your exposure to very long-term bonds. These are the ones most at risk from rising inflation and interest rates. Most people invest in bonds through mutual funds that have a mix of short-, medium- and long-term bonds.

How does your fund stack up? Just check the duration. That's a technical term that's the best measure of a bond's inflation and interest-rate risk. Longer-term bonds have longer durations. The fund company will post this number, usually on the monthly fact sheet on its Web site.

A short-term fund will usually have a duration of a few years. You will earn less money in short-term bonds, but you will face fewer risks. A fund with a duration beyond about six to seven years is taking on more risk.

2 Move some bond money into TIPS. Treasury Inflation-Protected Securities are bonds with built-in inflation protection. Right now, the 20-year TIPS bond promises to pay about 2% a year on top of inflation. By historic standards it's not steal -- but it's OK.

It offers a much better tradeoff between risk and reward than the regular long-term bonds. And it lets you sleep easy at night. With TIPS, you no longer have to worry about inflation. Bond prices can still move, but rarely by much -- and if you hold the bond for 20 years, it doesn't matter at all.

3 Consider some dividend stocks as well. Too many investors think in simplistic silos -- stocks are risky, bonds are safe, and so on. Yet stocks of many solid, blue-chip companies may prove very safe investments, especially if you buy a basket of them, and you buy them when they are cheap. (Meanwhile, bonds may prove very risky, especially if you buy them when they are expensive.)

Over time, stocks also have typically offered better protection against inflation than bonds.

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